7. Cost of Capital Flashcards
The company cost of capital is the right discount rate only for investments that have the _________
SAME RISK as the company’s overall operations!
The company cost of capital is the right discount rate only for investments that have the same risk as the company’s overall business
A firm’s value is stated as what?
A firm’s value can be stated as the sum of the value of its various assets
-> “The value-additivity principle”
How should we discount each asset in the value-additivity principle?
Each asset should be discounted at its own opportunity cost of capital
(its own level of risk!)
What is the “cost of capital”?
The cost of capital is estimated as a blend of the cost of debt and the cost of equity. This blended measure is called the weighted-average cost of capital:
What is the “cost of capital” equation?
where:
V = D + E
D = value of debt Debt
E = value of Equity
What is important to remember about the rdebt in the COC equation?
Interest is a tax-deductible expense for corporations
We multiple the rdebt by (1-TC)
where TC = marginal corporate tax rate
What is this equation called?
After-Tax Weighted Average Cost of Capital
(WACC is the traditional view of capital structure, risk and return)
How would we calculate requity for the COC equations?
EXPAND CAPM
where:
rf = risk free rate
rm = expected market return
Rm-Rf = market risk premium
B = beta of stock
Which beta is more reliable? Individual companies, or Industry portfolios?
Because of the variability of Beta financial managers often turn to INDUSTRY betas.
The portfolio beta is more reliable than the betas of the individual companies.
When looking at the WACC, it seems easy to increase by taking on debt, but is this true?
NO
The cost of debt is always less than the cost of equity.
The formula suggests that the average cost of capital could be reduced by substituting cheap debt for expensive equity.
It doesn’t work that way – As the debt ratio D/V increases, the cost of remaining equity also increases, offsetting the apparent advantage of more cheap debt.
What is the asset beta based on?
Company cost of capital (COC) is based on the average beta of the assets
What is the equation used to calculate asset beta?
A production facility with high fixed costs - relative to variable costs, is said to have______
A production facility with high fixed costs, relative to variable costs, is said to have HIGH OPERATING LEVERAGE.
What does high operating leverage also mean?
High operating leverage means a high asset beta.
What is the Asset Beta also equal to (another equation?)
BETA of revenue!
If these are some possible expected cash flows next year, what happens if there is an additional belief that there might be a 10% chance of making a 0 cash flow?
The unbiased forecast drops from 1M to 900k,
which results in a PV of $818,000
What must we do when converting an expected cash flow to a certainty equivalent?
We must discount the cash flow which is now a safe cash flow, at the risk free discount rate!
where:
Ct = risky cash flow
CEQt = certainty‐equivalent cash flow at the risk‐free interest rate rf
Project A is expected to produce CF = $100 million for each of three years. Given a risk-free rate of 6%, a market risk premium of 8%, and beta of .75, what is the PV of the project?
